Tuesday, February 3, 2009

Broken Pension Model?

Economic conditions have resulted in the largest annual decline in global pension fund assets "for many years", as the total value of pension pots fell 18% in 2008 to $25trn (€19.6trn), according to research from International Financial Services London (IFSL).

In its Pension Markets 2009 report, IFSL said pension fund returns in most countries turned negative over the year as most asset types fell in value, with an average return of -19% across OECD-member countries in the first 10 months of 2008.

The report stated exposure to equities had contributed to the negative returns in most countries, although it also highlighted the impact of "diversification into alternative asset classes that turned out to have much higher correlation to equities in a market sell-off than anticipated".

It noted pension assets in jurisdictions that required large weightings in domestic government bonds were the best protected, although a decrease in estimated liabilities as a result of rising corporate bond yields also helped to offset the decline in assets.

Figures showed the value of global pension assets dropped from $30.4trn at the end of 2007 to $25trn at the end of 2008, the majority of which (64%) were held in the USA while the UK is the second-largest market with an 11% market share, Canada holds 5% of total assets and the Netherlands, Australia and Japan each hold 3%.

The IFSL research pointed out at the end of 2007 pension fund assets had exceeded 100% of national income in Denmark, the USA, the Netherlands, the UK, Australia, Canada and Switzerland.

Meanwhile, pension assets valued at between 50-110% of GDP had been accumulated in Finland, Chile, Sweden and Ireland by the end of 2007.

In 2008, however, the report showed all countries included in an analysis by the OECD had reported a negative rate of return in the first 10 months, with Ireland, the USA, Australia and Canada reporting the largest negative returns of between 20-20% each, while the smallest falls were recorded by Italy at -6%, although Spain and Germany both reported -7% returns.

The research also highlighted trends in asset allocation in recent years among five of the largest countries for managing pension assets – the USA, the UK, the Netherlands, Japan and Australia.

It noted the allocation to equities has dropped in the UK from 67% in 2003 to 56% in 2007, following a fall in the share of domestic equities in pension portfolios, while equity allocation remained stable in the USA, Australia and the Netherlands but increased from 44% to 51% in Japan over the same four-year period.

The IFSL said bond allocations "fell sharply" in Japan from 45% to 32%, primarily as a result of reduction sin domestic bond holdings, while the USA also saw a decrease in bonds from 34% to 30%.

In contrast, investment in bonds doubled in the UK over the period, from 15% to 30%, while schemes in the Netherlands also increased holdings from 40% to 43%, although investment by Australian schemes remained stable at 21%.

Figures showed the allocation of assets to cash, real estate and other investments varied between the five countries, with Australia holding around 25% in other investments, including 10% in both cash and real estate, while Japan has 12% in assets such as hedge funds, private equity and derivatives, compared to a 7% allocation to both cash and real estate in the UK.

The IFSL also said although returns on listed alternative funds fell as steeply as equities in 2008, there was "evidence of growing interest in alternative assets from European and Asian pension funds, as schemes sought diversification and gave more priority to absolute return and less on index risk. Gold proved to be the most successful diversifier".

Other findings from the report showed the high equity allocation in these five countries is not reflected in other parts of the OECD, as in 10 countries, including Norway, Denmark, Poland and Spain, bonds accounted for more than 50% of the total assets at the end of 2007.

In addition, the IFSL stated that investments in equities makes up less than 10% of the total pension assets in seven countries, including Belgium, the Czech republic and Italy.

Elsewhere the research highlighted long-term deficits in occupational defined benefit schemes in a number of countries, and in 2007 the six French and six German companies listed in the Dow Jones STOXX 80 had the largest aggregate deficit of 4% and 2% of market capitalisation respectively.

Figures showed, however, that companies from the UK, the Netherlands and Switzerland, included in the index had an aggregate surplus of between -0.1% and 0.9% of market capitalisation, although IFSL admitted, "this masks a broad spread with some companies recording a deficit".

But despite their poor performance, most pension funds are sticking with alternative investments. Consider the New York State Common Retirement Fund, down 20% in 2008:

New York Comptroller Thomas DiNapoli said Tuesday the state's public worker pension fund has lost about 20 percent of its value to the global financial meltdown and needs more flexibility to invest in vehicles other than stocks to help recover.

Addressing public employee union representatives, DiNapoli said the fund is "secure" and diversified, with more than enough money to pay pensions.

But he warned that contribution rates may have to be increased in 2011 and 2012. DiNapoli said the rates have been cut five years in a row.

The fund's real estate and private equity investments have outperformed the stock market, which is down 35 to 40 percent and not expected to recover for years, the comptroller said. But the fund is near its legal limits in those investments.

The New York State Common Retirement Fund was valued at $154 billion last March 31, near its historic high. It had 677,321 active members and 358,109 pensioners and beneficiaries, paying out some $6.8 billion in benefits in the 2007-08 fiscal year.

In late October, Dinapoli said the fund had lost about 20 percent of its value, or almost $31 billion since April 1.

The fund has essentially stayed at that level, Dennis Tompkins, spokesman for the comptroller's office, said Tuesday. It was $121.7 billion on Dec. 31, with $39.5 billion in domestic equities, $15.3 billion in international equities, $42.1 billion in fixed-income investments, $12.5 billion in alternative investments, 49.3 billion in real estate, and $3 billion in what a comptroller's report called absolute return strategy.

"The concern, though, is after a year like this, what will it mean for the rates in 2011, what will it mean for the rates in 2012?" DiNapoli said. "There are ways for us with some legislative help to have an even more flexible and smarter strategy of investments that we think in the long run will help us to grow the fund in the right kind of direction."

Heavy losses in international investments caused performance of the state pension fund last year to lag behind the vast majority of public pension funds across the country, putting a chink in Treasurer Tim Cahill’s record of growth over the last five years.

Cahill, who chairs the pension fund board, and pension fund staff have pointed out that the Massachusetts Pension Reserves and Investment Trust fund outperformed the S&P 500 Index, a standard measuring stick that lost 36 percent in 2008. But the nearly $16 billion in losses the fund incurred in 2008 compared unfavorably to nine of 10 public pension funds nationwide.

Overall, the fund shed $15.9 billion in 2008, falling from $53.7 billion to $37.8 billion, a 29.4 percent fall. The average public pension fund fell 25.9 percent in that time, with the PRIT fund ranking in the 93rd percentile of all funds, according to the Trust Universe Comparison Service (TUCS).

“Compared to our peers, we have more of the pension fund invested in international stock than we do in fixed income bonds, which performed better than stocks did in 2008,” said Cahill spokeswoman Francy Ronayne.

In 2008, the state pension fund’s international stocks lost 42.3 percent of their value, and emerging markets investments lost 55.5 percent. The fund’s fixed income holdings gained 0.2 percent, the only investment class that grew at all.

Fund officials say that the deep losses resulting from international stock holdings may be painful now, but maintain that international stocks are still a smarter long-term strategy than other investment asset classes.

The poor one-year performance is a stark turnaround from the fund’s long-term success. Over the last five years, PRIT finished in the top 25 percent of funds across the country, growing at 3.53 percent, and over the last 10 years, it finished in the top 14 percent, with growth of 4.66 percent, according to TUCS, which ranks public pension funds. The PRIT fund has gained 9.3 percent since its inception in 1985.

The board that oversees the PRIT fund is required, as part of efforts to erase long-term unfunded pension liabilities, to seek an annual return of at least 8.25 percent on its investments.

As the stock market continues to roil, Cahill sought to quell a call for a change in investment strategy for the fund.

“This would be absolutely the wrong time to panic or make major changes,” Cahill said at a board meeting. “This is a catastrophic event in the markets. I think that funds that change their strategy for the long-term ... will underperform. When you’re in it, it’s like being in a storm. It’s hard to deal with it. Historically, this board of trustees has not panicked, not changed, and we’ve reaped the rewards of that.”

Cahill was responding to comments from board member, Robert Brousseau, who worried that maintaining the same investment strategy could lead to continued losses.

“Unless we do something to try and break the mold ... the whole theory of investing could be changing,” Brousseau said. “Maybe we have to think outside of the box.”

Cahill said the markets “probably haven’t hit bottom yet” but that even if the board had opted for a “defensive position” earlier on, it would have missed some of the big gains from prior years, and the fund would probably be at the same level it is now.

“The challenge that faces you as trustees is that 8-and-a-quarter,” he said, noting that the fund would look very different if the goal was simply to avoid losses. “That eight-and-a-quarter hangs over people at this table.”

Mr. Cahill sure sounds confident but if I was sitting on his board, I would be backing up Robert Brousseau 100% and asking that the Fund adopt a more defensive stance. Had they done this a couple of years ago, they would have missed some upside but they would have protected against severe downside risks, which is ultimately what every pension fund should be doing!!!

Instead, they are fixed on this 8.25% which is a ridiculous target to achieve in these markets unless you take more risks. And where did Massachusetts PRIM take their risks? Where else? Alternative investments like private equity, real estate and hedge funds.

The state pension board also decided at a meeting in Boston today to dismiss Ivy Asset Management, the hedge-fund unit of Bank of New York Mellon Corp., because several senior managers have left the firm. About $430 million in pension assets were invested with Ivy and $130 million with Austin, the board said.

Austin invested pension assets with Tremont Partners, the hedge-fund unit of Massachusetts Mutual Life Insurance Co. Tremont placed money through its Rye Select Broad Market Prime Fund LP with Madoff, the New York financier accused of fraud in a scheme that may have cost clients $50 billion.

“We have learned from this,” State Treasurer Timothy Cahill said at the meeting. The pension fund has examined all of its hedge-fund portfolios and “found that there are no other Bernie Madoffs in the funds,” Cahill said.

Massachusetts’ state pension has about $4.2 billion in assets in absolute-return strategies and portable-alpha investments, which try to beat market benchmarks by investing in hedge funds.

The pension fund’s hedge-fund holdings dropped 19 percent in 2008, while the average fund of hedge funds fell 20 percent last year, according to Chicago-based Hedge Fund Research Inc.

Supervision Questioned

Members of the pension’s investment staff told the board in a report today that Austin, based in Austin, Texas, didn’t adequately monitor its investments. While Austin executives had said they would visit investment managers once a year, they hadn’t gone to Madoff since 2005, the report said. Austin is owned by the asset-management division of KeyCorp.

Tremont had $3.3 billion invested with Madoff, a person familiar with the matter said in December. Of that, the firm’s Rye Investment Management unit had $3.1 billion, virtually all the money it managed, with Madoff.

Ivy Asset, based in Jericho, New York, manages about $7.5 billion in assets. The Massachusetts pension plan terminated the contract with Ivy after the hedge-fund manager cut 30 percent of its 165-member staff and key executives departed. Co-President Michael Singer and Stuart Davies, the head of investments, left last month.

Ivy Asset’s portfolio declined 20.03 percent last year, 8 basis points less than its benchmark hedge-fund index, according to the pension board report. During the past three years, Ivy Asset declined 0.97 percent annually, trailing the index by 11 basis points, the report said. A basis point is one-100th of a percentage point.

“Due to continued organizational changes, combined with poor investment performance, staff no longer has confidence in Ivy,” the report said.

Mike Dunn, a spokesman for New York-based BNY Mellon, declined to comment. Laura Mimura, a spokeswoman for Cleveland- based KeyCorp also declined to comment, citing client privacy policies.

At least Massachusetts PRIM is transparent about their hedge fund investments. I can list a number of large Canadian public pension funds that keep their investments in hedge funds very secretive. Even CPP Investment Board, which is far more transparent than its Canadian peers, gives few details on the hedge funds they invest with or the benchmarks that govern these investments.

But the bubble in alternative investments has popped and along with it, the pension model is broken. Pension fund managers can no longer hide behind alternative investments and bogus benchmarks to justify their big fat bogus bonuses.

Private equity scion Henry Kravis told industry peers, investors and clients yesterday that the buyout industry needs to change drastically in order to survive amid the economic turmoil that has led to a drying up of the debt such firms have traditionally relied on to make money.

The co-founder of US-based buyout giant Kohlberg Kravis Roberts & Co (KKR), which owns businesses including retail chemist chain Boots in the UK, told an industry conference in Berlin the industry needs to find new ways of making money "or fold up our chairs and exit stage left."

Kravis said his firm is seeking alternative investment opportunities instead of buyouts, as it waits out the credit crisis, including distressed debt, mezzanine financing and infrastructure."You have to accept the fact that transactions will be smaller and have far less leverage," Kravis told gathered attendees at the conference. "That means all of us have to adapt. We have to change the way we'll do business."

Pointing to the alternative investments, Kravis said: "We have to make our capital go further."Kravis added that with more than $400 billion of investor-pledged cash sitting on the sidelines in the private equity industry, it could play a role alongside governments in shoring up financial institutions or investing in infrastructure.

"We must acknowledge the reality that we have to adapt, to accept and take on a greater responsibility, and to work to rebuild the shattered trust of the marketplace," said Kravis.

Founded in 1976, KKR rose to prominence during the debt-fueled leveraged buyout craze of the 1980s, when it orchestrated the era-defining $25 bn takeover of tobacco and food giant RJR Nabisco in 1988 that was the subject of the book Barbarians at the Gates.

The firm then benefited with rivals as the credit boom than took place between 2003 and 2007 led to huge growth in the industry. But the economic slowdown has now left many private equity investments struggling under mountains of debt.

Kravis also said buyout firms could seek to invest in distressed financial assets taken over by the US government, which Barrack Obama's administration wants to sell.

Quoting General Eric Shinseki, former Chief of Staff of the US Army and current Secretary of Veterans Affairs, Kravis added: "If you don't like change, you're going to like irrelevance even less."

The Walkers Group also thinks the financial crisis will rehape the private equity industry, predicting that the impact of the financial crisis could leave the private equity industry transformed following a wave of consolidation, or completely reinvented with a brand new model for doing business.

The research, which draws on forecasts from more than 700 private equity respondents, looks at trends expected by the industry this year.

Simmons & Simmons said that one of the key predictions PE houses are expecting to see is consolidation, with 79% saying that 2009 will see the alternative investment sector consolidate.

Many private equity firms, which relied upon high amounts of leverage, face a very difficult year as their portfolio companies are hammered in the current market.

They are also under pressure from investors, who in many cases are struggling to fulfil their financial commitments to funds, and are demanding more control on the capital they allocate - including better terms on fees.

Within the hedge funds industry, where investors withdrew a record $152bn in the fourth quarter of last year, there have already been a number of mergers pushed by the need to keep assets under management at a minimum level.

Arthur Stewart, head of UK private equity at Simmons & Simmons says: "We've seen three recent hedge funds mergers, and we could now start to see consolidation between hedge funds, private equity firms and perhaps even boutique corporate finance advisory firms. All driven by the liquidity needs of large institutions and the future ability of some funds to raise new money."

Mr Stewart also says that at the top end of the market, these larger consolidated funds, could start to "fill some of the gaps left by the recent failures of investment banks."

The data goes on to examine sectors that buyout firms will shun or favour this year, with 89% of respondents saying they would avoid retail and leisure sectors and 80% tipping the alternative energy sector and infrastructure sectors for growth.

Finally, the report looks into the structures within PE houses, including the controversial rates at which management fees are set.

Mr Stewart says: "There is a need to differentiate between short-term changes in the market, such as having less debt, and there being more distressed companies, and longer-term structural changes, including the structure of private equity funds and their carry and fee arrangements.

"Although we can expect investors will carefully due diligence their managers' past record the expected debate on fee levels and profit shares will be tempered by the quality of the manager and its track record."

Almost three quarters of surveyed pension funds expect a negative net-of-fee performance of more than 5% on their hedge fund investments for 2008, suggests IPE research.

Within the remaining quarter of 73 respondents to the survey, pension fund officials said the expected returns for 2008 was evenly split between -4.9% to 0% and 0.1% to 5%.

Despite the turbulence encountered, only nine out of 30 respondents reduced their strategic asset allocation to hedge funds last year, while 13 left it unchanged and 8 pension funds even increased theirs, the research revealed.

“The strategic weight increased as the hedge funds performed in absolute terms better - ie less negative - than other asset classes so our trustees decided not to take [any] money back from the hedge fund manager but [instead to] increase our weight,” said one UK scheme.

In similar fashion, 15 out of 29 respondents said they do not plan to change their strategic allocation in 2009, in contrast to eight which plan to reduce their allocation, and six pension funds which aim to increase theirs in the hope of diversification and strong returns.

One Danish pension fund even said: “With the 2008 meltdown behind us, timing is [now] likely to be right to start investing.”

Yet of the 44 respondents that currently do not invest in hedge funds, only 27% plan to invest in the asset class in 2009.

When it came to the annualised net-of-fees performance since the first investment, the picture looked somewhat different to that of 2008: 12 of 29 respondents put the performance at between 0.1-5%, while 10 pegged it at 5.1-10%.

Interestingly, only seven respondents suffered a negative performance and these were all pension funds which had made their first hedge fund allocation between 2006 and 2008.

Despite the negative headlines hedge funds made in 2008, the vast majority, - over 76% of 30 respondents – claimed to still have confidence in hedge funds.

As one UK pension fund summed up: “Although our confidence is somewhat damaged due to the Madoff scandal, it was good to hear that our fund manager had the due diligence not to invest with Madoff.”

In the IPE survey of 73 pension funds, 40.5% were invested in hedge funds, while 59.5% said they were not.

This exuberance on hedge funds is ill-founded as the vast majority of hedge funds deliver "disguised beta" which can be passively reproduced using a few futures contracts. Moreover, the myth of fund of hedge funds adding value has been exposed.

The recovery of many hedge fund strategies is likely to slow in the coming year as outflows from an overhang of redemptions are likely to continue into the foreseeable future, according to Man Investments last quarterly review for 2008.

Event-driven and relative value styles will be the slowest to recover in the future, according to the report.

Some positions that are still crowded could force more selling if the market stays weak or deteriorates, while the liquidity premium accessed through non-traded instruments, which have few exit strategies available, has now turned to a discount.

The idea of absolute or risk adjusted returns with little market risk has also suffered in the current market environment and it will be difficult for hedge funds to gather and keep assets in the future.

However, while the process of deleveraging in the financial system is making allocating risk capital extremely difficult, the authors of the report have estimated that it is reaching its final stages, and hedge fund performance will rise when credit markets improve.

Hedge funds were down more than 19 per cent in 2008. They recorded their worst quarter ever in the final months of last year, as every style except managed futures and global macro suffered double digit losses.

In a sign that the smart money remains nervous about the state of credit markets, hedge funds are shying away from involvement in distressed debt.

In the past, hedge funds have been major players in the secondary market for loans gone bad, and the junkiest of junk bonds. Distressed debt has traditionally provided solid returns to sophisticated, specialized funds.

But a recent industry survey by Thomson Reuters HedgeWorld, picked up by TD Waterhouse, showed just 36 per cent of hedge fund managers held distressed debt investments, “down from nearly half of all respondents in 2007 when the opportunities on the market were far less lucrative.”

The hedge funds are steering clear despite unprecedented opportunities to put their money to work in credit markets. TD Waterhouse cited a Merrill Lynch report that showed “more than 70 per cent of the high-yield debt market is currently trading at distressed levels,” which is 1,000 basis points over U.S. government Treasuries.

The chief economist of the big CB Richard Ellis commercial real estate brokerage company brought more bad news to Orlando this week, warning that the nation's commercial real estate downturn is already worse than the 1991 collapse and shows no sign of abating.

Veteran economist Ray Torto said the current slowdown is "more similar to the Great Depression," of the 1930s, "not as bad, but it's more severe than anything else."

Torto spoke late Monday to more than 120 brokers and other industry professionals meeting in Orlando. "It was worse than I expected," Bill Moss, head of CBRE's Orlando division, said of the glum forecast. "But it is what it is."

Torto said that Florida's office vacancy rate most likely will continue to climb and likely peak in 2012 at more than 25 percent, as the state's economy continues to suffer from the pullback by consumers and ongoing job losses.

Torto said that much of the state's impressive job creation from four or five years ago was mostly because of the historic construction boom and now that real estate is the hardest hit sector is hurts Florida more than most other states.

But Torto conceded that his forecast of more pain ahead for the next several years is really dependent to a large degree on just how successful, or unsuccessful, the federal stimulus spending might prove to be, and how quickly the beneficial impact spreads throughout the economy.

"There is a lot of money on the sidelines," Torto said, that could flood back into real estate and other sectors quickly, if signs of a rebound are stronger than people expect.

Torto said Orlando's commercial real estate slump likely will peak in 2011, a year before the state as a whole, and Orlando's vacancy levels will not be as severe as the far larger Miami market, where the construction boom was bigger and the ties to weak Latin economies are stronger.

Moss, a longtime Central Florida real estate expert, said that he thinks it is important for the industry to face the grim facts and weak forecasts, even though public discussion of that "contributes to the fears" that make investors and consumers even more cautious.

In response to the special questions on commercial real estate lending, significant net fractions of both foreign and domestic institutions reported having tightened over the past year all loan policies about which they were queried. At the same time, about 15 percent of domestic banks, on net, indicated that the shutdown of the securitization market for commercial mortgage-backed securities (CMBS) since the middle of 2008 has led to an increase in the extension of new commercial real estate loans at their bank.

All this to tell you that "alternative investments" are no panacea and pension funds that continue to blindly invest billions into them will get clobbered in 2009 and beyond.

It's not just the hedge fund model that is broken; the pension fund model is broken too and pension funds that do not adapt will die.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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